What really scares economists about the present crisis? That despite spending more than 11 trillion dollars (including guarantees) by governments and central banks the crisis will spiral into global recession and deflation. One very effective way to trigger global recession is trade protectionism, when countries trying to protect their troubled industries impose import duty or non-tariff barriers on offshore producers. When one country does this then other countries follow with retaliation and trade collapses, more jobs are lost which  leads to recession. We have seen this happening in 1930s.

See chart below (thanks go to David Wheelock from Fed St.Louis), which shows monthly value of imports in 75 countries between 1929 and 1933. Trade implosions happen, you have been warned.

We (Pawel Opala and Krzysztof Rybinski) wrote a paper on Gordian knots of the 21st century. Abstract and link are below. Comments welcome!!!

In this paper we identify four Gordian Knots of the global economy in the 21st century, that is 1) limits to growth: scarce energy and natural disasters, 2) aging of the developed world and the 21^st century as the age of migration, 3) the rise of China and the failure of democracy, and 4) rising significance of global financial markets and emergence of new global players.

We describe what policies are adopted at international and European level to deal with these Gordian knots and assess, when it can be done, what are the strengths and flaws of these polices. Finally we suggest “outside-the-box” Alexandrian solutions to some of these problems.

We argue that while the natural resources constitute limits to growth in the medium run, the humanity ability to develop disruptive innovations will challenge those limits in the long run. We therefore call on the Club of Rome to broaden its discussion as what appeared as the main Gordian knot of the 21st century some 30 years ago should now be seen in a broader context. Europe has immense challenges and opportunities lying ahead. It is high time that the Club of Rome warns politicians which so diligently take Europe towards the dead end called global marginalization. Lack of strategic vision, national patriotism, protectionism, inability to see developing countries as legitimate global players. All these strategic weaknesses will strike back and will lead to weak Europe, unable to play an important global role in the 21st century. It is not to late avoid this gloomy scenario.

Opala, Rybinski paper is here. Comments welcome!!!

I spent last two weeks on holiday in Tuscany, Italy, in lovely Montaione area. Great food, great weather, the only negative were mosquitos, which bite real bad at night. I was surprised as mosquitos were much worse that in Cambodia or Myanmar, where I spent two weeks last November. Anyway, I was cut off from news and internet, so when I came back I found the world moving in direction I anticipated. US subprime problems are spreading, eating into other asset classes, equities now seem to caught the virus as well. Despite these developments IMF has upgraded its global growth forecast for 2007 and 2008 to 5.2%, versus 4.9% in April WEO, raising the credit and other financial risk profile.

I also noticed that there was a deluge of analytical work arguing that globalization no longer reduces inflation, on the contrary it adds to inflation. Some analysts conclude that this is the end of great moderation, and we should brace for a period of higher inflation, higher interest rates and rock-and-roll on financial markets. While more financial volatility is certainly ahead of us (subprime, credit derivatives, more fund closures) I disagree with those who predict globalization will push inflation up. See below why:

• Swedish study says that despite enlargement big EU states are gaining power, see EUobserver article . It also says that because of personality Luxemburg leader weighs probably more than a country of 12-14 million population.
• Bloomberg article commenting on US deicsion to put tariffs on imports of coated paper from China. Quotes: ” Figures last week showed the world’s central banks have the lowest level of U.S. currency in their foreign-exchange reserves since at least 1999. Dollar holdings dropped to 64.7 percent in the fourth quarter, according to the International Monetary Fund, down from 65.8 percent in the previous quarter and from as high as 72.6 percent in mid-2001. The euro is at its most popular since its 1999 introduction, with a share of 25.8 percent.” [...] ” The U.S. can hardly claim to be a paragon of free trade. In his book “Making Globalization Work,” for example, Nobel Prize- winning economist Joseph Stiglitz says there are 25,000 U.S. cotton farmers enjoying $4 billion of annual subsidies. Without those government payments, “it would not pay for the United States to produce cotton; with them, the United States is the world’s largest cotton exporter,” he writes.” [...] ““We see U.S. protectionism as a key long-term risk,” T.J. Bond, Hong Kong-based chief Asia economist for Merrill Lynch and Co., said in a research note today. “The economics aren’t going to change. If it interferes with the global flow of goods and capital, protectionism could raise global inflation as well as U.S. bond yields.”

  “Do Not Meddle in the Affairs of Dragons, For You Are Crunchy and Taste Good With Ketchup,” is a slogan available on T-shirts and bumper stickers. Maybe some champion of free trade could buy a box of each and send them to the gaggle of short- sighted, crowd-pleasing U.S. politicians as a warning that if you pull the tail of the Chinese dragon, you might be devoured.”

• Joseph Stiglitz wrote an article on managing globalization in TimesOnline. I like one quote:

” The thrust of my book is that there are alternative ways of organising each of the major areas in which globalisation has intruded. Here, I talk about an alternative – a medical prize fund. The international community could get together and say we will provide a prize for those who come up with a vaccine or cure for the kinds of diseases that afflict those in developing countries. With that prize there would be incentives for drug companies and researchers all over the world to do research to find the cures and vaccines against these diseases. But then, once the cure or the vaccine has been developed, we would use the force of the competitive marketplace.“

I like this quote because it is very much alike my proposal to come up with alternative energy fund, that will pay a prize, a bilion or a few billion dollars/euros for a working innovation that replaces oil and gas and makes European/World economy less delendent on energy supplies from countries that make energy as XXI century weapon.

• Peterson Institute’s Fred Bergsten and Edwin Truman testify before House of Representatives Budget Committee on why US deficit matters, plus tables with major holders of US debt. A quote: “Trade policy is not the topic of this hearing, but I would note, before closing, that the creation of US barriers to imports of goods or capital would be an ineffectual and wholly inappropriate response to our trade and current account deficits. As indicated throughout my statement, these large imbalances are a macroeconomic problem that requires macroeconomic (including exchange rate) remedies. It would be particularly counterproductive to discourage inflows of direct investment or any other forms of foreign capital, which we must continue to attract as long as we run current account deficits”.
  
• Niels Jensen of Absolute Return Partners writes an article in MoneyWeek stating that politicians and ptotectionism are biggest threats to continued global prosperity. A quote: “Protectionism is not the right way forward. Never has been, never will be. The fact that China is guilty of one of the greatest economic crimes of all times is no justification for increased protectionism. As long as the global economy strolls along, as it evidently does at the moment, the cries for increased protection(ism) are no more than distant drums, serving as a reminder of things to come. In a recession the drums will get louder and louder until the pressure becomes too much to bear for our elected politicians and they give in. At that point, we would almost certainly have a nasty bear market on our hands.”

I have read many articles about dangers of protectionism, defined as rich countries punishing poor countries for being price competitive. Such protectionism can even lead to global recession. This is “income effect” of protectionism. But many articles forget to notice the “substitution effect” of protectionism. By substitution effect I mean accelerated trade,investment and education links between China (or broader, Asia) and Africa. Over next few years this will not make a big difference, but demographics and Asia quest for knowledge economy implies that Chinafrica is the real globalization story in the long run. So politicians should think of both effects when they ponder trade or investment barriers.